The Marital Residence: A Complex Financial Asset

September 2003
By Carl M. Palatnik

In the article "Thinking About Settlements: Should Retirement Plans Be Discounted for Taxes?" published in the June issue of New York Family Law Monthly, I explained that retirement plans are complex assets, comprised of both tax-deferred (asset) and taxable (liability) components. Because of this complexity, I explained that the true value of these assets is context-dependent and closely tied to the financial situation of the ultimate owner. Attempting to divide these assets equitably in the one-dimensional environment of the yellow legal pad is not without peril.

Tax-Free and Tax-Deferred Compounding

The marital home, often the second financial centerpiece of a marriage, is also a complex asset that must be divided in the context of the overall division of other assets and income. Under current law, assuming certain conditions are met, an individual can exclude from taxation up to $250,000 in profit on the sale of the marital home ($500,000 if remarried). In addition, any profit (capital gains) over and above this amount, if subject to taxation at all, is usually taxed by the Federal government at the low rate of 15%.

Suppose the value of the home at the time of divorce is $300,000. Suppose also that the subsequent annualized rate of growth of the home is 6.78%, the annualized rate of appreciation since 1980 of homes in New York according to the Office of Federal Housing Enterprise Oversight, financial regulator for Fannie Mae and Freddie Mac. Compare this with an investment earning 6.78%, compounded, but taxed annually at a rate of 25% (Figure 1). Because of tax-free and tax-deferred growth, the home is worth approximately $32,000 more at the end of 5 years, $85,000 more at the end of 10 years and $170,000 more at the end of 15 years. Obviously, this differential continues to expand the longer the holding period.



While the home in generally considered a nonliquid asset, this need not necessarily be the case. For example, it is possible to withdraw equity in the home on a regular and tax-free basis through a reverse mortgage, which has the added benefit of not requiring monthly payments. And, theoretically, capital gains taxes might eventually be due on all but $250,000 of profit on the home. This, however, need not necessarily be the case, either. Under current law, the tax basis in the home is stepped up on the death of the owner, limiting capital gains to appreciation subsequent to death. Although this step up in basis becomes limited to $1,300,000 in 2010, this date also coincides with a repeal of the estate tax.

Leverage, Holding Period and Return on Investment

The rate of appreciation of an investment in a home is a function of both the owner's equity in the home and its market value; this phenomenon is known as "leverage." In addition, as with many other investments, the future value of the home is not guaranteed and is subject to certain risks. Historically, the longer the holding period, the smaller this risk. Although the annualized rate of appreciation of homes in New York over the past 23 years has been 6.78%, the rate of appreciation has been 10.59% in the past year. Further, it has been decelerating over the past few quarters. Some metropolitan areas in other regions of the country have even shown negative growth during this recent period. Even with extended periods of ownership, despite the historical trend, there is no guarantee the home will appreciate.

Consider a home worth $300,000. At a fixed rate of growth of 6.78%, the home appreciates $20,340 during the first year and, assuming there is no mortgage, the owner's return on investment is 6.78%. Alternatively, assume the owner has a $260,000 mortgage and $40,000 of equity. Assume also a 25-year mortgage at a fixed rate of 7%. The portion of mortgage payments attributable to principal increases the owner's investment in the home to $43,978 by the end of the first year (for purposes of illustration, this scenario assumes that the after-tax cost of mortgage interest is exactly offset by the after-tax earnings of an alternative investment). Due to leverage, the owner's return on investment during the first year is 46.25% (a $20,340 return on a $43,978 investment) instead of 6.78%. Further, the accelerated return on investment continues to outpace the unleveraged home for approximately 11 years (Figure 2).



Importance of Context

When it comes to settling the home, financial issues have often taken a backseat to emotional issues. Obviously, in certain situations, the home can be a good investment. But the home can also be a bad investment. This will ultimately depend on the financial context in which ownership will reside, ie, how the other assets and income will be divided and what the actual costs of home ownership will be.

While the home may often be a good place to start negotiations, decisions relating to "taking" the home or purchasing a new one with proceeds from the sale of the home, should not be made in isolation. While these are not traditional equitable distribution issues, equitability cannot be achieved without adequately addressing with your client questions such as the following: What is the fair market value of the home? What is the cost of alternative housing? How long does the client plan on staying in the home? What is the housing market like in his or her area? Will he or she need a mortgage? How much of a mortgage will he or she be able to get, how much will he or she be able to afford and how much would be financially ideal for him or her to assume? Will the client be able to afford insurance, utilities, repairs, taxes and other costs of maintaining the home? Will he or she be able to keep pace with inflation? Will he or she have money available for emergencies? Will he or she be able to save money for college or other future expenses? Will he or she be able to meet expenses when the child support or spousal maintenance ends? Does the client need to insure these payments against premature death or disability? How will home ownership affect his or her standard of living? How might that affect the children? Will he or she need to find additional sources of income to make ownership of the home workable? What will the client need to do, what are the costs and what are his or her prospects for obtaining this income? Would the client have the time and other resources to afford to do this? How much social security will he or she eventually be able to collect? Will he or she need to trade rights to retirement assets or borrow from a retirement plan to obtain ownership of the home? How will this affect his or her ability to support him- or herself now and in retirement?

Retirement Assets

Retirement assets and the marital home are often the major financial centerpieces in a divorce. Retirement assets are complex and contain both taxable and tax-deferred components. The value of these assets varies with the context, ie, the income and assets in which they are ultimately placed. See, "Thinking About Settlements: Should Retirement Plans Be Discounted for Taxes?" New York Family Law Monthly, June 2003.

The marital home is also a complex asset, consisting of tax-free and tax-deferred components and otherwise favorable tax treatment. Mortgage interest and property taxes are usually tax-deductible, the capital gains rate on the sale of the home is usually capped at 15% and gains can often bypass estate taxes and be stepped up upon death, potentially making them tax-free. Mortgages also leverage investments in the home. This can accelerate the appreciation potential of the home, but also increases risk, especially if the home will only be owned for a short period of time.

Conclusion

Unlike retirement assets, home ownership involves maintenance costs and, frequently, the assumption of debt (the mortgage). Although the appreciation potential of an investment in the home is related to the size of the mortgage, the costs of home ownership must be analyzed in the context of the distribution of other assets and income. Cash flow projections are particularly important to ensure the workability of a particular outcome. Failure to do so can lead to inequitable settlements and financial disasters.

Although the main focus of this discussion has been on two of the major marital assets in a divorce, an important corollary is that all asset classes have unique sets of characteristics and therefore need to be analyzed in an integrated and multidimensional fashion for equitable solutions to be achieved. So long, yellow pad. May you rest in peace.
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